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Global financial crisis - financial institutions in the future

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Introduction

Welcome to the fourth in our series of surveys tracking market sentiment in relation to the global financial crisis.

In the wake of the G20 summit, it is clear that we are now entering a new phase in the global financial crisis, where there is less of a need to respond to immediate events. It is becoming clear that although politicians are seeking a coordinated international response to the global financial crisis, it has not affected every territory and every sector of the financial services industry in the same way. A more thoughtful approach is emerging as politicians and regulators seek to rebuild the financial system for the future.

Although there are some signs of improvement, the recent announcement of further quantitive easing measures by the Bank of England, with a commitment to spend £50 billion of newly created money to purchase bonds and the ECB’s announcement of it’s own quantitive easing programme with a pledge to purchase €60 billion (£53.4 billion) of covered eurobonds (heralded by ECB president Jean-Claude Trichet as “unprecedented in nature, scope and timing”), show that governments and central banks still need to provide fresh stimuli to support recovery. In the US , the results of the recent stress tests undertaken by the US Treasury and federal regulators, revealing that 10 out of 19 of the financial institutions tested will need to take further steps to shore up their capital buffers by a collective $74.6 billion (£49.6 billion) reinforces the point that there is still much to be done. Recovery will come, but no-one can predict when. In the meantime, businesses in the financial sector need to prepare themselves for that eventuality.

In our earlier surveys we examined market reaction, first to the credit crunch, as the impact of sub-prime defaults in the US began to restrict liquidity in the banking sector and then to the dramatic events of last autumn as the credit crunch became a full blown global financial crisis. In this fourth survey we are beginning to look towards recovery. The theme is “Financial institutions in the future”. In particular, we have solicited respondents views as to whether they think financial institutions will need to change in order to compete in the new environment and if so, how. We consider the role that regulation will play in shaping the new world and attitudes to risk management.

This survey was conducted in the immediate aftermath of the G20 summit in London in April 2009. Our aim is to stimulate informed debate on the issues that are facing financial institutions at the present time. By identifying the issues we hope to assist in identifying solutions.

Executive summary

The fourth in our series of surveys tracking market sentiment in relation to the global financial crisis examined the theme of “Financial institutions in the future”. We surveyed 197 respondents (comprising financial institutions and other mainstream corporate entities) between 6 and 15 April 2009. The online survey was designed to canvass the views of financial services professionals on the impact of the latest phase of the global financial crisis, following the G20 April 2009, on the future for financial institutions.

69% think the financial institutions landscape has changed forever

68% think better regulation could have prevented the global crisis

61% believe global regulation of financial institutions is not practical

52% said tighter regulation will impede recovery

68% believe risk management should be given increased resources but only 47% thought firms would actually make the necessary investment

83% agree more focus on remuneration structures is required as part of risk management

75% said state intervention in financial institutions has been effective

84% feel not enough is being done to rid the banking system of toxic assets

66% expect financial institutions to significantly reduce the range of products and services they offer

Financial institutions in the future

Do you think that the financial institutions landscape has fundamentally changed forever?

Nearly 70% of respondents agree that the financial institutions landscape has changed forever but, surprisingly, 30.5% disagree. In view of the sweeping changes to regulation being considered, as well as the damage wrought to individual institutions during the crisis, it is difficult for many to imagine that things will ever be the same again, and received opinion backs the majority. The demise last year of Bear Stearns and of Lehman Brothers in the US , and the numerous problems faced by UK banks, have led to the state becoming an active, interventionist player both as an investor and as a regulator. This is unlikely to change for some years to come.

Yet a substantial minority does believe that the financial institutions have not changed forever, so it will be interesting to see if a full recovery does indeed take place in due course and confound those who expect even more profound change in the sector.

I can understand why there is such a sizeable minority view. Economic downturns occur with almost predictable regularity although the underlying causes will vary. This time financial institutions and their regulatory framework are said to be largely to blame. Now that the dust is settling and there is a return to a more settled, stable market and principles of sound banking are reinstated, I am inclined to think that we may be surprised at how comparatively modest the changes will be. In the main, free markets operate at their best with a comparatively light regulatory touch and although there almost certainly will be some tightening up over the next year or two the recent “irrational exuberance” experienced in the city will continue to calm down and I rather doubt that there will be material long-term effects (or changes). Life will go on.

Survey respondent

The legacy of this recession will have an impact on financial and economic activity for at least the next 50 years.

Survey respondent

The landscape will change for the next 3 to 5 years but there is every chance of a return to another period of exuberance as and when bank liquidity reaches sufficiently high levels and hence banks compete on pricing and structure once more.

When do you think the economic effects of the global financial crisis will dissipate?

It is important to take a balanced view of the global financial crisis. It will take time to play through – there is no short-term sugar-coated pill that financial institutions can take to remedy things. They must remain focused on the future, and prepare themselves for recovery so that having learned their lessons of the recent past they are well placed to compete in the future. There is much they can do, in terms of looking at the structure of their business, how it is capitalised, how it is governed, and the manner in which it operates and the products which it offers. Experience counts for everything at the moment and we are fortunate that there are still many of us around who have seen many of the problems that are confronting financial institutions before, and can help them work towards optimum solutions.

We asked our respondents about their views as to when the economic effects of the global financial crisis would begin to dissipate. The responses show some signs of optimism, with over 45% believing that this will happen over the next 12 months. However, it is true to say that the majority were less optimistic, with over 50% believing that it will take at least two or more years.

This is despite increasing talk among economists of “green shoots”, vast expenditure by governments on bail-outs and other forms of assistance for financial institutions, and the generally positive sentiment in the markets following the G20 meeting in London in April. Even in the UK, the country which will be worst hit by the financial crisis according to the International Monetary Fund, the Bank of England’s chief economist Stephen Dale has said “it is most likely” that “we will see some signs of recovery by around the turn of the year.” In the US , the Federal Reserve Bank chairman Ben Bernanke has started to sound more optimistic, arguing that there are signs that “the sharp decline in economic activity may be slowing.” President Obama has referred to “glimmers of hope” for the US economy.

While the respondents’ views will be regarded by many as optimistic, they represent a positive shift in sentiment compared to our previous survey Credit crisis: the long-term implications for a turbulent market (October 2008). The International Monetary Fund does not expect a modest global economic recovery before 2010, while the Organisation for Economic Co-operation and Development said in April that “the picture for all countries remains weak with the outlook in the United States, Canada, Japan and the major non- OECD economies in particular further deteriorating.” The OECD’s indicators for the world’s leading economies offered little comfort and industrial production is falling globally and retail spending is sluggish in most countries.

Jeff Barratt, global head of projects, London, on the current lending climate:

Finance is available, but lending banks are being much more restrictive than in the past, focusing on relationship lending and then only to good projects or where there is a demonstrably good business rationale. Lending margins are also high with banks often imposing prepayment penalties for early repayment.

When do you expect liquidity to return to the banking system?

The majority of respondents believe it will take 12 months or less for liquidity to return to the banking system, though a sizeable minority (23.9%) see it happening earlier. This could be seen as optimism in the sector. There have been plenty of positive developments in the banking sector recently, and ample evidence of liquidity, suggesting that banks will soon be in a position to boost lending. Goldman Sachs moved back into profit in the first quarter of 2009, JP Morgan Chase reported higher profits than were forecast by most analysts while expressing confidence that it could repay $25 billion of federal aid without raising fresh capital, and HSBC successfully concluded a vast £12.5 billion rights issue. Even Citigroup, one of the banks worst affected by the crisis, beat consensus forecasts and made a profit in the first quarter.

Lending in China has already been given a big boost, with record new loans of $277 billion being made in March for investment projects. In the UK, the Prime Minister, Gordon Brown, has said banks will provide an extra £50 billion of lending in 2009. In the US, lending by commercial banks has remained steady: even in the last quarter of 2008, it grew at an annualised rate of 5.5% according to Federal Reserve data.

Martin Scott, partner, London, looks at the link between confidence levels and available liquidity:

It will take some time before liquidity returns to the banking system. There are residual concerns about the many problem assets, such as asset-backed securities, that the banks are holding. Such securities are difficult to value so the markets will be nervous about them for the foreseeable future. We are seeing an improvement in the level of lending to good quality corporates, and a number of refinancings are now taking place. But the banks are being very discriminating, and they need to be because there is a large amount of debt to be refinanced in the next few years. Realistically, until the US economy improves, especially the housing market and the employment figures, we are unlikely to see the kind of confidence that could lead to a good level of liquidity.

Mario Lisanti, partner, Milan, on the need for diversification of risk:

For liquidity to return to the banking system it is essential that banks become again able to diversify their risk profile using capital market instruments; otherwise, they will have very little underwriting capacity and available resources will be used (as they are currently) to restructure existing deals rather than to support new investments or transactions.

Which region will recover quickest from recession?

In recognition of the global nature of the financial crisis and acknowledging that not all regions have been hit in the same way, we asked our respondents for their views on where recovery would come first.

Most respondents choose either East Asia (including China) (36.7%) or North America (32.7%) as the regions likely to recover soonest from the downturn. This is perhaps not surprising as there have been encouraging signs from China while the US is traditionally seen as resilient, and there is evidence, as mentioned above, at least that the rate of decline is slowing. While the theory of a “decoupling” of emerging markets from the rest of world proved popular in our survey Credit crisis: The long-term implications for a turbulent market (October 2008), it is now evident that such economies are too dependent on exports to mature economies to be insulated from global recession. GDP growth in China was relatively slow at 6.1% in the first quarter of 2009, although this figure was an object of envy for most countries, and OECD figures on Chinese exports show that the pace of decline is slowing. Elsewhere in Asia, however, green shoots are few and far between.

Only 11.7% of respondents choose the Middle East; this is understandable while oil prices remain relatively low and the Gulf economies in general have close ties to other parts of the world facing recession. A slightly higher proportion, though still low at 14.8%, choose Western Europe, but all the signs are that the Eurozone economies are still shrinking.

Pavel Kvícala, partner, Prague, gives a CEE perspective:

There is a view in the CEE that the crisis has effectively been imported and that therefore the solution lies outside the region. This view is based on the fact that the CEE is typically an export region and that it would only be the growth in Western Europe and the US that would re-start growth.

There is definitely a sense that the credit crisis is an opportunity for Asian banks (and particularly Chinese banks) to increase market share in sectors that were previously dominated by the major Western financial players. There is therefore a real possibility that the medium-to long-term impact of the credit crisis will be to accelerate the shift in the balance of financial power from West to East.

Survey respondent

There is still a significant degree of uncertainty as to the impact of the economic crisis, particularly given the initial reaction of a number of regulators and governments across the global economy. Once the dust settles, we at least hope to be able to determine a way forward; until then, many financial institutions are resigned to an uncertain future.

Restructuring

As the global economy emerges from recession, do you expect financial institutions to reduce significantly the range of products and services they offer?

There is a general consensus that financial institutions will need to change in order to be in the best shape to compete as the global economy recovers. As one respondent to our survey puts it:

It is time for financial firms to return to a much more conservative approach to doing business. Frankly, the industry is in the last chance saloon…

Most respondents think it is likely (51.8%) or highly likely (14.2%) that financial institutions will cut back on the range of products they offer.

Banks and insurance companies alike are trying to “de-risk” and to “de-leverage” so it is all but inevitable that some institutions will withdraw from, for instance, riskier product lines and services.

As the world starts to recover from the recession, we would expect Islamic financial institutions to deepen their penetration of markets. The instruments called upon to achieve this will evolve and whilst we may see some conventional financial products disappear from the market, we would expect to see an increase in Islamic products.

Mario Lisanti, partner, Milan, on the impact of state intervention on products on offer:

State intervention in the banking world as well as more rigid regulatory and tax requirements will certainly reduce the range of banking products offered.

Tomas Gärdfors, partner, Frankfurt, on specialisation within the banking sector:

It is not unlikely that we will see financial institutions becoming more specialised. Some banks will focus on stable, local or regional retail business, with others focusing on investment banking and complex products. It is obviously important to retain sound competition in each market, but every bank may not be able or allowed to do every form of business.

Cathy Pitt, partner, London, on aversion to risk in the short term:

These responses reflect the heightened sense of caution we have witnessed from within financial institutions. Current thinking is that it is better to stick to what you know but I suspect this risk aversion will dwindle over time.

Survey respondent

This is a correction to the market which is probably five years overdue, following property problems in 1974, 1989 and therefore probably should have happened in 2004. The delay has allowed the systems to overheat and complete disregard for a downside to be understood.

Survey respondent

It’s time for financial firms to return to a much more conservative approach to doing business. Frankly, the industry is in the last chance saloon – irresponsible and opportunistic practices and behaviours will result in the total loss of public confidence in the financial system which has served the world so well.

Do you think state intervention in financial institutions and financial markets is effective?

It’s time for financial firms to return to a much more conservative approach to doing business. Frankly, the industry is in the last chance saloon – irresponsible and opportunistic practices and behaviours will result in the total loss of public confidence in the financial system which has served the world so well.

A big majority (75.6%) of respondents say that state intervention in financial institutions and markets is effective. This is an important ideological shift. The size of the majority is significant given that most of the respondents work in financial services and would probably, before the financial crisis, have been much happier with minimum state interference. In our survey Credit crunch: Are you legally protected (April 2008) nearly half of the respondents said they did not agree that regulators should be given more powers to intervene in financial institutions. Most observers now, believe that, without large-scale state intervention in the financial services sector, the fall-out from financial crisis would have been far worse.

Even Goldman Sachs, one of the most successful financial institutions in the world, received $10 billion of federal government aid in the depths of the financial crisis. Only the state would have been capable of supporting the US insurance group AIG, into which around $180 billion of federal funds has been invested. Most observers believe that supporting AIG prevented even greater damage to the financial markets. In the UK, a number of banks would probably have collapsed and posed systemic risk to the entire financial institutions sector. In this context, it can only be surmised that the 24.4% of respondents who answered “no” to the question are concerned about the quality and nature of state intervention rather than about whether intervention was necessary at all.

James Bateson, global head of financial institutions, London, on large scale state intervention:

For most observers now, it would be difficult to believe that without large scale state intervention in the financial services sector, the fall out from the financial crisis would not have been far worse.

The head of the International Monetary Fund believes that more should be done to clean up the “toxic assets poisoning the global banking system”. Do you agree?

Respondents in overwhelming numbers say that not enough is being done to rid the banking system of toxic assets. IMF managing director Dominique Strauss-Kahn said in April at the G20 that “you never recover before the cleaning up of the banking system has been done. The US supports further stimulus measures whilst the EU is more in favour of increased regulation. They are not yet moving quickly enough in doing the cleaning up of the financial system.” Plans have been formulated in certain countries, however. In the US, a detailed plan was announced in March to develop a “public-private partnership” to buy up and remove toxic assets from banks’ balance sheets, but clearly this has not been moving fast enough in Strauss-Kahn’s view – nor according to most respondents. The plan has already run into political difficulties after it provoked protests for allowing banks themselves to take part as buyers of toxic assets. In the UK, a different approach has been taken: instead of removing the assets from the balance sheets, they have been underwritten by the state. Other major economies have yet to deal with the problem directly, although Germany, which already has a bank rescue fund, is considering further action.

Neil D Miller, global head of Islamic finance, Dubai, looks at possible lessons to be learnt from the ethics of Islamic finance:

Realists in the Islamic finance community know that their young industry will not replace conventional finance despite the crisis but the USP of Islamic finance is its clear ethical foundation and this can offer some guidance as to how to avoid future recurrences. Realising that money should operate as a measure of value rather than a value creator would be a change of emphasis for the banking system. A return to “old fashioned” banking, where assets are identified and risks properly measured and understood, would also help; Islamic finance properly conducted is meant to exhibit these values. The Shariah Supervisory Committee applies an additional tier of scrutiny based on religious principles but perhaps more financiers should ask themselves the ethical question before closing each deal: are we doing the right thing?

David Whear, partner, London on restoring confidence amongst banks:

Cleansing the system of the so called “toxic assets” is an important step in restoring confidence of banks in each other. The establishment of Equitas in the UK to deal with 1994 and prior year liabilities was a crucial component of the plan to reconstruct and renew the Lloyd’s insurance market, when it faced near collapse in the beginning of the 1990’s, and the success of Equitas has contributed significantly to the subsequent success of Lloyd’s.

Karl Rogers, partner, Dubai on confidence in the banking system:

Confidence in the global banking system will only be restored when banks and financial institutions, whether under pressure or direction from regulators or governing bodies or voluntarily, have taken decisive action to clear their balance sheets of highly leveraged products that are not liquid and have little or no underlying tangible security. Even when such action has been taken on an institution by institution basis, an adequate regulatory or corporate governance environment will need to be in place to ensure that the likelihood of further incidences of “toxicity” is considerably reduced.

Regulation

Do you think better regulation could have prevented the current global financial crisis?

Many attribute the severity of the global financial crisis to a failure in regulation. There is a general sentiment that tougher regulation is required to prevent the problems of the past from recurring and that a greater degree of international co-operation is necessary. But there is concern that a one-size-fits-all approach fails to acknowledge the different geographical and market segmental impact of the crisis and as one respondent puts it:

The danger is that heightened regulation will be applied universally to bank products rather than be specifically focussed on those bank products (and hybrids thereof) which led to the current economic condition. Other bank products work very well within their existing forms of oversight. Over-regulation across the board could have the effect of strangling recovery at birth.

So regulators and legislators will need to walk a tightrope so as not to stifle recovery, or impose unnecessary burdens on those segments of the industry which have not been at fault. Clearly there have been significant real and political needs to act and to be seen to act decisively. But as one respondent observes:

The industry has to be careful that the push for change is effective, well thought through and not rushed due to political expediency.

More than two-thirds of respondents say that better regulation could have prevented the financial crisis. The IMF has been highly critical of regulators, saying in a recent report that they failed to spot the “big picture problem” of “a growing asset price bubble”, arguing they should “focus on activities, not institutions.”

Indeed the regulators themselves have now seemed to acknowledge this by arguing for an overhaul of regulatory regimes. A trio of reports by the authorities in the US , where former Federal Reserve chairman Paul Volcker led the Working Group on Financial Reform, in the UK, where the Financial Services Authority’s Lord Turner led a review (the Turner Review), and a European high level group mandated by the European Commission and chaired by former Banque de France chairman Jacques de Larosière (the De Larosière Group), all agreed that the market could not be relied upon to restrain itself. The era of “light touch regulation” is set to end. Lord Turner said, “The financial crisis has challenged the intellectual assumptions on which previous regulatory approaches were largely built, and in particular the theory of rational and self-correcting markets.” All of the reviews argued banks needed to be forced to set aside more capital during boom years, that all institutions which potentially posed a threat to financial stability should be regulated, and that there should be more scrutiny of ratings agencies. Others, including Bank of England governor Mervyn King, have raised the possibility of Glass-Steagall-style legislation, a reference to the 1930s measure in the US which separated investment banking from commercial banking until it was repealed in the 1990s.

It is quite obvious that better regulation could have prevented the crisis. In particular, most regulators failed to see the dangers of the Special Purpose Vehicles which didn’t have to be consolidated on bank balance sheets. As it turned out, there was huge pressure on the banks to step in and bail out these technically off-balance sheet vehicles. The reason why Spanish banks are in a better position than most other banks today is because Spanish regulators did not allow banks to keep SPVs off their balance sheets.

A completely different, and less “light touch”, regulatory culture and regime could have prevented the financial crisis. But I don’t think we should necessarily blame the regulators. They would have needed political support in order to interfere with financial models: before the crisis it would have taken considerable courage to have spoken out against some of the big financial services mergers, or to have carried out stringent stress tests on financial institutions, given the macroeconomic policies we were pursuing, and the economic growth we were enjoying. The Turner Review, however, suggests that the regulators now understand they will have to take a more activist stance and to take on a bigger burden.

Do you think tighter regulation could impede recovery?

At the time of writing it is easy to see how regulation could impede recovery. Although the US and UK governments in particular are asking the banks to lend more, the regulators are demanding that they manage their risks better – the corollary of which is “deleveraging” and less lending. The result is likely to be that banks shy away from risky loans that might rescue some of the many distressed companies which are trying to restructure their debt, and that they shun ambitious acquisition financings which might promote an economic recovery. On the other hand, a recovery will be very difficult to sustain without tighter regulation. Investors are unlikely to show confidence in the financial services sector if discredited “light touch” regulation continues.

Closer inspection of banks has become a political necessity for governments looking to avoid a repeat bail out of banks in the future and the recent round of US “stress tests” have been the subject of much media speculation amid concerns that gloomy results might cause another collapse of confidence in the sector just as it was beginning to enjoy a period of relative stability. As it has turned out, leaked reports of the results have meant that the final results have been received more calmly than anticipated and confidence has also received a boost from the confirmation by US Treasury Secretary Timothy Geithner that none of the financial institutions tested are judged to be at risk of insolvency. In the UK, the FSA has just announced a second round of more rigorous “stress tests” on the current health of the UK’s building societies. It looks as if for the immediate future “stress tests” are going to be a familiar feature of the political and financial landscape.

Tightening regulation by requiring banks to hold more capital against assets, as recent regulatory reviews have recommended, will lead to a more conservative approach by the banks and they will lend less. So there is a danger that regulation will impede an economic recovery. Even now, I don’t see a lot of new activity happening as many banks restrict their lending to existing customers, or cease lending to certain sectors such as commercial real estate altogether. The new regulatory regime will find it difficult to strike a balance as it seeks to ensure that the banking system is robust but not too conservative. I don’t think it’s practical to separate investment banking from commercial banking, for instance. Yet it is certainly inevitable and important that we have tighter regulation: something did go badly wrong since banks did not always understand risk.

Cathy Pitt, partner, London, on the need for targeted regulation:

People feel that regulation to date has been focused on the wrong areas. Effective regulation need not be tighter, but it must definitely be targeted on the real areas of risk.

Survey respondent

The danger will be that heightened regulation will be applied universally to bank products rather than specifically focussed on those bank products which led to the current economic condition (and hybrids thereof). Other bank products work very well within their existing forms of oversight. Over-regulation across the board could have the impact of strangling any recovery at birth.

Survey respondent

I do not believe the failure is to do with risk management deficiencies, it is to do more with corporate governance and the need to maintain shareholder returns – people expecting alpha returns are as much to blame as the board who did not understand the products in which they were trading.

Survey respondent

The industry has to be careful that the push for change is effective and well thought through not rushed due to political expediency.

Do you think global regulation is practical?

A clear majority (61.4%) believes global regulation of financial institutions is not practical. Cross-border co-operation on bail-outs so far does not hold out much hope for any future global regime. Belgo-Dutch bank Fortis had to be broken up in September 2008 amid rancour after a rescue package of €11 billion, which had been agreed initially by the Dutch, Belgian and Luxembourg authorities, fell apart. No one doubts the importance of global co-operation and it might be relatively easy to set up representative bodies of regulators. Indeed some have already been proposed, notably the G20 Summit’s Financial Stability Board. Proposals for some form of European system of financial supervision have also been considered by the de Laroisière Group and separately by the FSA in the recently published Turner Review. But financing bail-outs could be much tougher. As Mervyn King is reported to have said, “Global banks are global in life and national in death.” And as one unnamed central banker told the Financial Times, “The easy part was to get central bankers and regulators into the room. The hard part was to get the finance ministers in the room and get them to stay there.” It is highly unlikely that, as scholars of the financial world have pointed out, a stable financial system, an integrated financial system and national financial autonomy are all compatible.

Jonathan Herbst, partner, London, looks at the long road to regulation on a global level:

A global regulator is a long way off. A global regulator now would probably be impossible because of political and protectionist pressures: certainly, supervisory or enforcement powers for such an authority would be impossible to agree on. We are, however, seeing co-operation on specific regulatory initiatives and reviews such as that by Jacques de Larosière in France show that there is considerable momentum behind such moves, of which we will see more. That is to be welcomed. Realistically, all we can hope for are step changes towards global standards.

A global regulator would be very difficult to set up. The world isn’t yet ready for such a regulator because countries would be very reluctant to surrender their national powers to it. To be credible, it would need to have authority in the US and Europe as well as the major economies of Asia such as China, India and Japan. But what we will see, and what we’ve seen already, is a remarkable degree of co-operation among regulators in the big economies of the world. We look set for a global approach to the problems of maintaining financial stability, to the regulation of financial institutions and alternative asset management firms such as hedge funds and to transparency in the context of tax havens. This has not happened in the past and is to be welcomed in an increasingly globalised world.

The G20 summit called for the international community to agree to exchange information on tax matters. There has traditionally been significant reluctance to commit to information exchange. Reaching agreement is difficult since each country has its own tax system and must commit to information exchange in its double tax treaties (many of which would need to be amended to achieve this) or in other agreements.

The regulatory agenda at a European level is perhaps a more immediate concern for financial institutions with the European Commission setting an aggressive timetable for implementation of a pan-European regulatory response to the financial crisis. A communication from the European Commission is due shortly on detailed proposals with specific legislative measures scheduled for Autumn 2009. Early proposals are a source of concern. The announcement of a proposed EU directive to regulate the managers of alternative investment funds has received much criticism from analysts and industry bodies wary of reactive and inappropriate regulatory measures to areas of the financial sector not fully understood.

Risk management

It has been suggested that the global financial crisis reflects a complete failure of market discipline, do you agree?

In addition to regulatory failure, a break down in market discipline has been identified as a root cause of many of the problems. Tighter risk management controls would almost certainly have militated against the worst effects of the global financial crisis, if not averted them altogether.

Two-thirds of respondents say the financial crisis represents a complete failure of market discipline. This is in line with a recent report by the IMF . It said that “professional investors in equity and bonds failed to probe deeply enough into the nature of the assets they bought, and instead relied too much on credit ratings.” The problem was that they were “too optimistic” and missed the growing conflicts of interest in credit rating agencies. The IMF argues that market discipline needed to be strengthened, with measures, some of which have already been introduced, to reduce conflicts of interest at ratings agencies and also less reliance on ratings agencies, together with a new differentiated scale for structured products.

Neil D Miller, global head of Islamic finance, Dubai, on the more disciplined approach of Islamic banks to financial risk management:

The creation of sophisticated investment instruments and structured products that were several times removed from the underlying assets became frenzied. Shariah principles suggest that this sort of financial engineering is not a permissible activity and therefore, in theory, demonstrates a more disciplined approach by Islamic banks to financial management.

Dorian Drew, partner, London on the importance of strong risk management:

The global financial crisis has thrown into stark relief the importance of strong risk management processes, which encompass a clear understanding of complex products and how they react to extreme market conditions.

Do you think that better risk management at financial institutions could have helped to prevent the global financial crisis?

Nearly 89% say better risk management could have helped prevent the financial crisis. This is consistent with previous findings from Norton Rose Group surveys that financial services professionals do not absolve themselves of blame. As early as February 2008, 57% of respondents acknowledged that banks and other financial institutions did not have sufficient risk management processes in place, while 74% said the banks were “ultimately to blame for the credit crunch”. In response to a further question, 56% attributed the crunch to “poor business decisions by banks.” The liabilities and losses resulting from those errors are vast. The IMF estimated in January 2009 that total losses from the credit crisis to financial institutions worldwide could rise to $2.2 trillion, a figure that is close to the UK’s gross domestic product in 2008: there are reports that this estimate will soon be doubled. Much of the losses were attributable to structured financial products originating in the US , especially real estate securities, but the IMF also noted “degradation” in bank loan books. According to Andrew Haldane, executive director for financial stability at the Bank of England, “risk management models have during this crisis proved themselves wrong in a fundamental sense.” Banks could soon be forced to take action: the European Parliament is considering an amended version of the capital markets directive under which banks would be required to retain an interest in instruments which they securitise and also to impose limits on interbank lending.

Simon Lovegrove, know-how lawyer, London, looks at the findings of the Turner review:

On its own better risk management would not have prevented the financial crisis. However, as the Turner Review makes clear, improvements in the effectiveness of internal risk management and firm governance are now essential. The Review found that some very well run banks were affected by systemic developments over which they had no influence but there were also cases where internal risk management was ineffective and boards failed to identify and constrain excessive risk taking.

Erwan Héricotte, partner, Paris, looks at the attitude of the French regulatory authorities:

There are already signs that regulatory bodies such as Banque de France and AMF (French financial markets regulators) pay more and more attention to risk management and quality of investment and lending vehicles.

Patrick Bourke, Middle East head of dispute resolution, Dubai, on one of the challenges for the Middle East:

One of the challenges in the Middle East is how a slew of regulation will be implemented to mitigate risk, whilst not unduly stifling commerce and innovation.

Should risk management functions at financial institutions be given an increase in any of the following?

Do you think risk management at financial institutions will in fact be given an increase in any of the following?

Respondents broadly agree that more authority (75%) and resources (67.9%) should be given to risk management functions in financial institutions. Most also think that in fact risk managers will be given more authority (62.9%) while only a minority believe they will be given the resources (47.4%). The majority believes that external advisers, however, should not be given a more important role in risk management.

There is plenty of evidence that risk management has not, until recently, been a high priority for financial institutions. Risk professionals did not traditionally occupy many senior positions with the consequence that risk management was little understood. According to recruitment consultancy GRS, only 12% of UK financial services companies had a risk professional on the board as of July 2008. This is expected to rise to 50% by the end of 2009, with the number of UK financial risk roles surging from 1,000 at the beginning of 2009 to 4,000 by the middle of 2010. GRS said in late 2008 that its research suggested that 56% of financial institutions in London did not understand the risks on their balance sheets. And in a recent survey of the global investment management industry by SimCorp StrategyLab, a third of respondents said they did not actively monitor long-term strategic risk on an active systematic basis, while the number of organisations with a risk management function reporting directly to the board of directors dropped by 5% to 31% since 2007.

Peter Snowdon, partner, London, sees more value being placed on the role of risk management in the future:

A lot of risk models in financial institutions were inadequate, one of the key failures being that they were quite short term: most of them did not see this crisis coming. Risk management as a whole was perhaps not sufficiently valued and given as much importance in financial services as it was in other industries. Regulators are now pushing banks, insurance companies and investment firms to take risk more seriously and to have risk professionals, who have a strong background in risk, on their boards. On the other hand, it is important to place risk management in perspective, as it is quite easy to construct a risk management model that would prevent you doing anything.

Michael Newell, partner, London, comments on the link between good governance and risk management:

Financial institutions know that they must now reassess the link between good governance and risk management. Boards are being encouraged to provide stronger independent oversight of executive management and risk management is now likely to mean greater involvement from non-executives, more risk professionals sitting on boards and an increase in staff for risk management functions. Resource and budget increases for risk management will not be enough, rather cultural changes in terms of personal accountability and a stronger support culture for risk will need to be encouraged. Most fundamentally, firms need to address the challenges of linking remuneration policies to risk management.

Do you think financial institutions should be more focused on remuneration risk/reward structures as part of their risk management strategies?

If yes, where should the focus be?

Respondents overwhelmingly (83%) agree that financial institutions should be more focused on their remuneration structures as part of their risk management strategies. Some 41.6% say the focus should be on senior management level, while smaller minorities highlighted director and trader levels. Previous Norton Rose Group surveys have revealed that many finance professionals acknowledge the need for changes, but these latest responses suggest that opinion has moved even further. In our survey Credit crunch: are you legally protected? (April 2008), nearly 42% said there should be a move towards long term incentives while 40% came out against such a move. Respondents, apart from a minority of nearly 17%, have perhaps been influenced by the public debate. Compensation structures have been severely criticised, and not only in the popular press. While public outrage has centred on a handful of senior executives, a wider problem has been convincingly identified by more sober analysts. The IMF has said that one of the reasons for “market failure” was a “financial sector compensation system based on short-term profits” which “reinforced the momentum for risk taking.” Individuals, it has been argued, have been too concerned with their own short term rewards to consider the long term interests of their companies. The lure of these rewards contributed to the creation of new instruments which were, according to the IMF, “more risky than they appeared.” Already senior executives at banks have reportedly had to insert “no reward for failure” clauses into their employment contracts. International regulators at the Financial Stability Board say that pay should be adjusted for the risks an employee takes, as well as for performance, and should be deferred to take account of the duration of the risks being taken.

In the UK, Sir David Walker, former financial services regulator, is in the process of chairing an independent review of corporate governance in the UK banking industry. The Walker Review is examining a number of board and shareholder risk management issues including the effect of remuneration policies on risk taking practices. A consultation paper is to be published this summer with conclusions due in the autumn.

There has been a huge outcry over bonuses in the financial sector with many concluding that they had a role in causing the financial crisis by encouraging excessive risk-taking. The FSA draft code on remuneration, the Turner Review, the de Larosière Report, the Financial Stability Forum and the G20 summits have all focused on compensation models. Financial institutions will be forced by regulators to look very hard at their domestic and international remuneration structures across all levels, as these are now linked to risk management. The FSA’s draft code on remuneration, for instance, says that remuneration policies must be consistent with effective risk management and that risk management professionals should be closely involved in determining remuneration. It emphasises the importance of risk adjustment in compensation and of moving towards long-term performance measurement rather than simply looking at short-term revenues. Financial services regulatory law has never been so concerned with the individual employment relationship.

In the light of the global financial crisis, are financial institutions more likely to litigate disputes now than 12 months ago?

What will be the main subject of the disputes?

Most respondents (82.6%) expect financial institutions to litigate more disputes amid the recession than 12 months ago. Debt recovery, according to 82.2%, insolvency (63.8%) and structured finance/derivatives (55.7%) will be the main subjects of the disputes. Fraud (45.4%) and employment (30.8%) will also be important areas. In our survey Credit crisis: the long-term implications for a turbulent market (October 2008), the biggest areas identified were structured finance, derivatives, lending and debt recovery and fraud was not identified as an area for disputes at all. High-profile fraud cases involving Bernard Madoff and Allen Stanford have led to a re-assessment of the likelihood of litigation in the area of fraud.

Charles Evans, partner, London, on a more litigious climate:

There is plenty of evidence that financial institutions are engaging in more litigation. In a recession, they are more willing to litigate in order to recover much needed funds and they’re less distracted by the deal making of the boom years. Debt recovery is a big area, as are disputes over the mis-selling of financial products. Fraud is a growing problem as rogue traders of complex financial instruments are finding it increasingly difficult to hide their losses. Some institutions and investors have also found that structured finance products have exposed them to much greater risk than they expected and so they are taking legal action. More and more queries are coming in from investors seeking redemptions from hedge funds and other asset managers, who are often reluctant to give them their money back.

Many large cross-border transactions have been carried out in recent years, whose complex nature will inevitably result in an increasing number of litigations given the current difficult economic climate.

Patrick Bourke, Middle East head of dispute resolution, Dubai, on pre-dispute positioning tactics in the Middle East:

We are seeing an increase in activity with regard to pre-dispute positioning, analysis of contractual entitlements and obligations and the commencement of formal proceedings. There is already an increasing emphasis on eradicating corrupt practices of fraud in the Middle East, as evidenced by recent comments in the press by His Highness Sheikh Mohammed Bin Rashid Al Maktoum, Vice President and Prime Minister of the UAE and Ruler of Dubai, and Bahrain’s Crown Prince, Sheikh Salman bin Hamad Al Khalifa, who recently announced a possible new corruption law in Bahrain.

Michael Godden, partner, London, on a noticeable change in attitude to litigation:

There has been a noticeable change of approach in banks’ attitudes towards litigation in the last 6 to 12 months. They are generally far less reticent about suing counterparties and many banks seem increasingly willing to countenance the possibility of suing all but the largest players where the losses justify this. While it is unlikely that this represents a permanent change of attitude, the traditional “club rules” about not suing other banks are showing real signs of strain at the moment.

Methodology

In which segment of financial services do you work?

We surveyed 197 respondents (comprising financial institutions and other mainstream corporate entities) from 6 to 15 April 2009 to canvass the views of financial services professionals on the impact of the latest phase of the global financial crisis on the industry and the future for financial institutions. The survey was conducted online and respondents were given the opportunity to remain anonymous.